Why Q3 Earnings Season Doesn’t Matter

by Alyssa Oursler | October 8, 2013 11:45 am

Why Q3 Earnings Season Doesn’t Matter

While earnings season tends to steal the spotlight on Wall Street, things are bit different this time around. Third-quarter earnings, which have slowly started trickling out, are taking a backseat to the current circus in Washington.

“The debt ceiling crisis, first and foremost, is the most important thing for investors to be watching right now,” says Michael Farr, CNBC contributor and president of investment management firm Farr, Miller & Washington. “On top of that, the general political landscape, including the current government shutdown, is acting as a huge headwind for the broader economy.”

Of course, earnings growth overall — not in one particular quarter — still remains important for investors, as it is the most significant indicator of stock price performance long-term.

But earnings growth for the rest of this year and next are already expected to be modest at best — and the current crises in Washington are only going to make things worse.

Another Economic Headwind

It’s no secret that bottom-line growth has been OK in recent quarters, even amid tepid top-line growth. That trend has been going on for years, with earnings driven largely by cost-cutting and increased productivity.

It can’t go on forever, though — as illustrated by the fact that a record number of companies have already lowered their EPS guidance for Q3, according to FactSet[1]. Eventually, the top line needs to expand for the bottom line to continue growing.

The bad news: Sales probably won’t pick up amid the current political environment.

“If Washington really messes this up — if Washington truly approaches default, or lets the shutdown go on and on, even with some sort of stopgap measure on the debt limit — that top line won’t grow,” Farr said. “We’re already seeing economic headwinds — a slowdown in economic growth, consumer spending and consumer confidence — just in the past week. When faced with uncertainty, consumers keep their hands and their dollars in their pockets.”

To ram his point home, Farr cited an example given by Larry Summers concerning a study on consumer economic behavior.

Let’s say you have a consumer who wants to buy a refrigerator. There are three scenarios and outcomes:

First: If you tell her energy costs are going to be higher next year and the economy will be weaker, the consumer will buy an expensive, energy-efficient refrigerator.

Second: If you tell her energy costs will be lower and the economy will be stronger, she’ll spend more money on a top-of-the-line fridge.

But if you tell her the economy will be different and energy costs will be different, but don’t tell her how, she won’t buy a refrigerator at all.

“It’s a very understandable and intuitive example of how a consumer will stop and say, ‘I think I’ll wait — I need to know more information,’” Farr said.

“The bottom line is that, when we see this in Washington, it has a trickle effect, and it’s not a good one,” he said. “As this goes on, it could metastasize into something far worse. In fact, if this goes on longer-term, the government’s indecision or lack of resolution could put the country back in recession.”

How to Play It

Farr’s take on the current earnings season was sprinkled with some optimism, though.

To start, he noted that there is another possibility: that the troubles in Washington will go away. But even if that is the case, earnings season likely will be overshadowed, anyway — just by a relief rally.

Beyond that, a continued crisis could also mean great buying opportunities are right around the corner. Investors simply need to keep their cool.

“Emotion is the foe of the long-term investor,” Farr said. “Just look at smart money like Warren Buffett. Warren Buffett is not out selling, Warren Buffett is not panicking. Warren Buffett, if we see a real pullback, will start buying very aggressively.

“We have been through various crises before as a country, the world has yet to come to a screeching halt, and the gradual expansion of corporate America has been enormously reliable and robust.”

So for now, the best course of action for investors is simple: Stay calm — and don’t get caught up in the third-quarter earnings stir.

Instead, keep your eye on the crises in Washington — and remember they too shall pass.

Alyssa Oursler is an Assistant Editor at InvestorPlace.

Endnotes:

according to FactSet: http://www.factset.com/websitefiles/PDFs/earningsinsight/earningsinsight_10.4.13